Regarding the article on Argentina by W. Mondano, I think he is wrong first about the macroeconomic conditions and second about the probability that the Kirchners will be ousted. The macro conditions are not good because there is a lot of repressed inflation that is imposing an increasing cost on the economy (anyone familiar with Argentina’s economic history knows that repressed inflation has often been a serious problem and a sufficient condition for a rapid deterioration of the economy). And the Kirchners will hardly be ousted because they can mobilize huge numbers of “really bad” people to take the street to face a civilian opposition which cannot count on the support of any military force (only Presidents of the Radical Party failed to mobilize people to stop an incoming coup, as Irigoyen in 1930, Illia in 1966, Alfonsin in 1989, and de la Rua in 2001).

James Hamilton on oil and the dollar: Yet another example, and the one people often think of first, would be if there is a higher inflation rate in the U.S. than Europe. In that case we might expect to see an increase in the price of oil that exactly equals (in percentage terms) the decrease in the value of the dollar…The graph below plots the cumulative logarithmic change since 1999 in the dollar price of one euro along with the dollar price of one barrel of oil…

Why do we keep seeing this kind of reasoning from supposed authorities like Mr. Hamilton? The flaw should be quite obvious, but since I’ve seen it mindlessly and repeatedly perpetrated by a number of professors of economics over the last few months, allow me to tediously correct it: if greater inflation is expected in both the euro and the dollar, the price of oil will increase in both euros and dollars. The euro/dollar exchange rate reflects relative monetary changes between the dollar and the euro, and the monetary component of the dollar oil price reflects absolute monetary changes in the dollar. It is quite illogical to expect the relative and the absolute to be strongly correlated. If the monetary changes in the euro and the dollar are of similar magnitude and direction, oil and gold prices will go up or down for these monetary reasons while the exchange rate changes little for these reasons. If European and U.S. monetary authorities are reacting in similar ways to, for example, similar credit crunches, there is no reason to expect a substantial correlation between euro/dollar exchange rates and oil prices. We will see such correlation for monetary reasons only when they are reacting with substantially different magnitudes or in different directions.

In expectation terms, the euro/dollar exchange rate reflects relative inflation expectations and surprise relative inflation between the dollar and the euro, whereas the monetary component of the dollar oil price reflects absolute inflation expectations and surprise absolute inflation for the dollar.

Analyzing the weekly price quotes since 2000, I get a correlation coefficient of 93% between the dollar price of gold and the dollar price of oil — both absolute measures of dollar inflation expectations and surprise dollar inflation. The alternative hypotheses, changes in expectations and surprises in technological/geological supply or industrial demand, have very different effects on gold and oil that should lead to low correlations between their prices. The high correlation between gold and oil implies that oil as well as gold price changes are dominated by monetary factors. Many professional economists seem to be in denial about these basics of life under fiat currencies, perhaps since this ruins using the highly visible gas prices for simple chapter 1 lessons about how the fundamentals of consumption demand and supply by themselves are supposed to fully determine prices. These chapter 1 exercises, besides neglecting expectations, assume fixed-value currencies, and spectacularly fail for mineral commodities in our world of fiat currencies. In that world there is a monetary component to mineral commodity prices exponential in size to the expected inflation rate. This monetary component always dominates the gold price and at more than minimal levels of expected inflation (i.e. > ~2%/year) it also dominates oil prices, as demonstrated by the high correlation between gold and oil prices since 2000.

Bob Murphy, your testimony covers some good ground but it has some severe flaws. For example

Oil is a highly fungible commodity traded on a world market. As such, changes in the exchange rate between the U.S. dollar and other currencies translate immediately into the spot price of crude, quoted in U.S. dollars.

You seem to be in danger of committing the same fallacy that I debunked above. Monetary causes do not necessarily imply strong correlations between the euro/dollar exchange rate and oil prices — one reflects relative inflation expectations and surprises, and the other absolute. Furthermore this is wrong:

When the dollar falls against the euro, for example, the dollar-price of
haircuts in Texas may not rise in response. But the dollar-price of a barrel of crude will, because oil can easily be diverted to other paying customers in response to fluctuating currency values.

This is quite wrong because the difference between Texas and other crude can be arbitraged by transport, and price arbitrage based on expectations of this transport is reflected in prices practically immediately. For prices movements of weeks or years, and probably even of days, this effect is thus insignificant.

This, too, is also wrong:

Because oil inventories (at least in the U.S.) have not grown significantly from September 2007 through the present, and because there appears to be no strategic cutback in oil production during this period, it is unlikely that a large portion of the sharp rise in oil prices in the last nine months can be attributed to investor anxiety over future economic conditions [including monetary policy], because of the falling dollar or even a new war in the Middle East.

Oil production is only cut back until oil prices rise to reach the new net present value due to higher inflation expectations. Speculators, expecting such behavior (and also expecting them not to increase oil production in response to prices that just reflect inflation expectations), serve to drive this price rise in near real-time reaction to Fed and Treasury behavior and changes in expectations of same, thus there is no need for oil producers to substantially cut back. Producers mostly just follow the lead of speculators who have more information on the Fed than they do.

Bob: If I understand you, you’re saying this can’t be true, because arbitrage makes prices adjust almost instantly.

You’re not understanding me. My argument is that your West Texas Crude scenario gives rise to an arbitrage opportunity and my theory of inflation expectations does not. The effect of oil fundamentals on the dollar that you inferred from this scenario (in contrast to the reverse effect of the changing dollar and changing euro on oil prices in my theory) is thus transient and insignificant.

how do they get their customers to purchase the same amount (actually, more!) of product at double the prices as before? Only if demand has gone up.

This demand puzzle is a problem for any theory, whether monetary or fundamental. The answer is that despite all the recent political sci-fi rhetoric to the contrary, oil is a superior form of energy, often with no economical ready substitutes, as well as a great chemical feedstock. Automobiles in particular give us quite valuable real options that the vast majority of us actively seek and are extremely reluctant to give up. When gas prices go up we cut back on luxuries and many other kinds of necessities to make room for greater gas expenditures. Alternatives are typically costly status items, like hybrids, that are not practical substitutes for most people. As a result the demand for oil is far less elastic than for most commodities. Furthermore, because this is largely a monetary not a fundamental effect, the costs of alternative energies and conservation are also inflating — they are simply much stickier than oil prices and will thus lag but eventually catch up to them. Investments in them will turn out far worse than a mere fundamental analysis would indicate, and enough people remember the 1970s, and how tacky and dangerous the small cars everybody bought in the late 1970s and early 1980s seemed by the late 1980s, that this has made people more reluctant to buy small or alternative in the current runup. Adding to oil’s inelasticity are the many countries that subsidize fuel consumption.

Observe that this inelasticity and these subsidies, while important for explaining the demand puzzle you have set forth, have not changed substantially as dollar oil prices have climbed by more than a factor of 10 since 1998. The component of the demand curve reflecting fundamentals has gradually risen, but it has also risen by a similar proportion in many prior decades and can’t explain any dramatic increase in oil prices. What has changed are inflation expectations, driven by increasing government deficits and expected central bank behavior in response to the credit crunch, among other monetary factors. Our higher oil and gold prices reflect, exponentially, the increase in these expectations.

You have failed to point out any mistakes that I have made, much less any “basic mistakes.”